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Merrill Lynch in Japan Merrill Lynch is an investment banking titan. The US-based financial services institution is the world's largest underwriter...

1) The Search for Capital in the Czech Republic

Following the collapse of Communism and the shift toward a more market-oriented system, the Czech Republic initially emerged as one of the more vibrant and market-driven economies in Eastern Europe. By early 1998, however, the economic development of the Czech Republic was being held back by a shortage of capital. The problem was rooted in macroeconomic conditions and institutional problems.

On the macroeconomic front, 1997 saw a combination of adverse developments, including a rise in inflation, a growing government deficit, and a speculative attack on the Czech currency that forced the government to abandon its fixed exchange rate policy for a floating exchange rate system. After the shift to a floating exchange rate system, the Czech currency declined by about 10 percent against the German deutsche mark and over 15 percent against the US dollar. Since many internationally traded commodities, such as oil, are traded in dollars, this devaluation added fuel to the Czech Republic's inflation rate fire. The government responded by tightening monetary policy, raising interest rates to around 16 percent.

These macroeconomic problems had a predictably negative effect on the Prague stock market. The PX50, the key index of Czech shares listed on the Prague exchange, declined from around 520 to a low of 430 by June 1998. Much of the decline was due to foreign investment capital leaving the country for more attractive investment opportunities in neighboring Hungary and Poland, where macroeconomic conditions were more favorable and where local stock markets were performing better.

But that was not the only problem for the Prague stock market. Many Western investors had been discouraged from investing in Czech stocks by the poor reputation of the Prague stock exchange. That institution is reportedly rife with stock manipulation by insiders, insider trading that would be illegal in more developed markets, a lack of protection for minority stockholders, poor corporate reporting, and fraud. Also, most state-owned enterprises in the Czech Republic were privatized through a voucher scheme that has left the majority of shareholdings in the hands of institutions and groups that are preoccupied with maintaining control over their companies and opposed to any attempt to raise capital through new equity issues. Consequently, the Prague stock market is small and liquidity is very limited.

These factors have combined to increase the cost of capital for individual Czech enterprises. Traditionally, many Czech firms forged tight relationships with banks and borrowed money from them. However, with interest rates at 16 percent and many banks reining in credit to make up for past largesse, it was increasingly expensive for Czech companies to raise capital through borrowings. As for the Czech stock market, its poor reputation and low liquidity made it almost impossible to raise capital by issuing new shares. In mid-1997, one of the Czech Republic's most dynamic and profitable new enterprises, Bonton, a film and music company, attempted to raise $30 to $40 million through an initial public offering on the Prague exchange. This would have been only the second IPO in the history of the Prague exchange, and the only one of any significance. A successful IPO would have helped to legitimize the market, but Bonton canceled the IPO when the market declined to yearlong lows in the wake of the Asian financial crisis.

Despite all these problems, most agree that the Czech economy has a bright future. However, this future cannot be realized unless Czech companies can raise the capital to invest in the necessary plants and equipment. A number of prominent Czech companies in 1998 announced their intentions to make international equity issues. At the beginning of 1997, only two Czech companies had foreign listings, both of them large banks. However, another five significant companies sought listings on the London stock exchange in 1998. In a sign that this strategy may work, the first company to list shares was Ceske Radiokomunikace, a state-owned radio, television, and telecommunications company that successfully raised $134 million in equity by listing Global Depository Receipts on the London exchange, increasing its equity by 36 percent and decreasing the state holding in the company to around 51 percent.

Discussion Questions: What are the causes and likely consequences of the capital shortage faced by Czech firms? How will selling equity to foreign investors benefit Czech firms and the Czech economy? Can you see any drawbacks with the strategy of selling equity to foreign investors?

Merrill Lynch in Japan Merrill Lynch is an investment banking titan. The US-based financial services institution is the world's largest underwriter of debt and equity and the third largest mergers and acquisitions advisor behind Morgan Stanley and Goldman Sachs. Merrill Lynch's investment banking operations have long had a global reach. The company has a dominant presence in London and Tokyo. However, Merrill Lynch's international presence was limited to the investment banking side of its business until recently. In contrast, its private client business, which offers banking, financial advice, and stock brokerage services to individuals, has historically been concentrated in the United States. This is now changing rapidly. In 1995, Merrill Lynch purchased Smith New Court, the largest stockbrokerage in Britain. This was followed in 1997 by the acquisition of Mercury Asset Management, the United Kingdom's leading manager of mutual funds. Then in 1998, Merrill Lynch acquired Midland Walwyn, Canada's last major independent stockbrokerage. The company's boldest moves, however, have probably been in Japan. Merrill Lynch started a private client business in Japan in the 1980s, but met with limited success. At the time, it was the first foreign firm to enter Japan's private client investment market. The company found it extremely difficult to attract employee talent and customers away from Japan's big four stockbrokerages, which traditionally had monopolized the Japanese market. Plus, restrictive regulations made it almost impossible for Merrill Lynch to offer its Japanese private clients the range of services it offered clients in the United States. For example, foreign exchange regulations meant it was very difficult to sell non-Japanese stocks, bonds, and mutual funds to Japanese investors. In 1993, Merrill Lynch admitted defeat, closed its six retail branches in Kobe and Kyoto, and withdrew from the private client market in Japan. Over the next few years, however, things changed. In the mid-1990s, Japan embarked on a wide-ranging deregulation of its financial services industry. This led to the removal of many of the restrictions that had made it so difficult for Merrill to do business in Japan. For example, the relaxation of foreign exchange controls meant that by 1998, Japanese citizens could purchase foreign stocks, bonds, and mutual funds. Meanwhile, Japan's big four stockbrokerages continued to struggle with serious financial problems that resulted from the 1991 crash of that country's stock market. In November 1997, in what was a shock to many Japanese, one of these firms, Yamaichi Securities, declared it was bankrupt due to $2.2 billion in accumulated "hidden losses" and would shut its doors. Recognizing the country's financial system was strained and in need of fresh capital, know-how, and the stimulus of greater competition, the Japanese government signaled that it would adopt a more relaxed attitude to foreign entry into its financial services industry. This attitude underlay Japan's wholehearted endorsement of a 1997 deal brokered by the World Trade Organization to liberalize global financial services. Among other things, the WTO deal made it much easier for foreign firms to sell financial service products to Japanese investors. By 1997, it had become clear to Merrill Lynch that the climate in Japan had changed significantly. The big attraction of the market was still the same: the financial assets owned by Japanese households are huge, amounting to a staggering ¥1,220 trillion in late 1997, only 3 percent of which were then invested in mutual funds (most are invested in low-yielding bank accounts and government bonds). In mid-1997, Merrill started to consider reentering the Japanese private client market. The company initially considered a joint venture with Sanwa Bank to sell Merrill Lynch's mutual fund products to Japanese consumers through Sanwa's 400 retail branches. The proposed alliance would have allowed Merrill Lynch to leverage Sanwa's existing distribution system, rather than having to build a distribution system of its own. However, the long-run disadvantage of such a strategy was that it would not have given Merrill Lynch the presence
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that it felt it needed to build a solid financial services business in Japan. Top executives reasoned that it was important for them to make a major commitment to the Japanese market in order to establish the company's brand name as a premier provider of investment products and financial advice to individuals. This would enable Merrill Lynch to entrench itself as a major player before other foreign institutions entered the market--and before Japan's own stockbrokerages rose to the challenge. At the same time, given their prior experience in Japan, Merrill Lynch executives were hesitant to go down this road because of the huge costs and risks involved. The problem of how best to enter the Japanese market was solved by the bankruptcy of Yamaichi Securities. Suddenly Yamaichi's nationwide network of offices and 7,000 employees were up for grabs. In late December 1997, Merrill Lynch announced it would hire 2,000 of Yamaichi's employees and acquire up to 50 of Yamaichi's branch offices. The deal, which was enthusiastically endorsed by the Japanese government, significantly lowered Merrill Lynch's costs of establishing a retail network in Japan. The company got off the a quick start. In February 1998, Merrill Lynch launched its first mutual fund in Japan and saw the value of its assets swell to $1 billion by April. By mid-2002, Merrill Lynch announced it had $12.9 billion under management in Japan. However , the collapse in global stock markets in 2001-02 hit Merrill’s Japanese unit hard. After losing $500 million in Japan on its investment, in January 2002 the company fired 75 percent of its Japanese workforce and closed all but cight of its retail locations. Despite this costly downsizing,the held onto almost all of the assets under management, continued to attract new accounts,and by mid-2002 was reportedly making a profit in Japan. Case Discussion Questions 1. Given the changes that have occured in the international capital markets during the past decade,does Merrill Lynch’s strategy of expanding internationally make sense ? Why ? 2. What factors make Japan a suitable market for Merrill Lynch to enter ? 3. Review Merrill Lynch’s 1997 reentry into the Japanese private client market. Pay close attention to the timing and scale of entry and the nature of the strategic commitments Merrill Lynch is making in Japan. What are the potential benefits associated with this strategy?What are the costs and risks?Do you think the trade-off between benefits and risks and costs makes sense?Why? 4. The collapse in stock market values in 2001-2002 resulted in Merrill Lynch’s Japanese unit incurring significant losses.In retrospect, was the Japanese expansion a costly blunder or did the company simply get hit by macroeconomic events that were difficult to predict and avoid? 5. Do you think Merrill Lynch should continue in Japan?Why? The goal for the new Merrill Lynch subsidiary is to have $20 billion under management by 2000. The company got off to a quick start. In February 1998, Merrill Lynch launched its first mutual fund in Japan and saw the value of its assets swell to $1 billion by April. The company now has a significant head start over other foreign financial service institutions contemplating building a private client network in Japan. Merrill Lynch's hope is that by the time other foreign institutions enter, it will already have a commanding presence in Japan that will be difficult to challenge.
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